Tax-Smart Health Care Spending with HSAs, FSAs and HRAs

Most of us get our health care through our employer, but some of us buy it independently. Almost always, there are choices we must make among various types of healthcare plans. Annual enrollment usually happens in the fall, so now is a good time to start thinking about it.

Not all employers or healthcare plans offer them, but there are three types of tax-advantaged health care spending arrangements:  Health Savings Accounts (HSAs), Flexible Spending Accounts (FSAs), and Health Reimbursement Arrangements (HRAs). All three can provide significant tax savings on health care expenditures.

Health Savings Accounts (HSAs)

An HSA is kind of like a healthcare IRA. The primary qualification is that you must be covered by a “high deductible health plan” (HDHP). In 2020, an HDHP must have a minimum deductible of $1,400 for an individual or $2,800 for a family.

Bear in mind that while most health insurers offer high deductible policies, not all such policies are qualified for HSA plans. The insurer must agree to federal reporting requirements. If you are in doubt, check with your health insurance company to verify that their HDHP complies.¹ 

Contribution limits to HSAs are not as high as for IRAs. For 2020, maximum contributions are capped at $3,500 per individual and $7,000 per family. Those over age 55 can contribute an extra $1,000 annually as a catch-up contribution.

Your employer may sponsor an HSA program, but you can also open an HSA on your own. You are not required to spend the money in an HSA. In fact, I would encourage you to let it grow tax-free for as long as possible!

Many employers who offer HDHPs make it easy for their employees to set up HSAs and make contributions through their payroll. However, the HSA custodian chosen by your employer may not be a good fit for you. (For example, they may not offer no-load mutual funds.) You can often still make payroll contributions if you fill out a form from your chosen HSA custodian. If for some reason your employer won’t cooperate in this, you can opt out of contributing pre-tax dollars to the employer’s HSA. Instead, just contribute post-tax dollars to your chosen HSA account (which can be done in a lump sum), and take a tax write-off at the end of the year to reduce your taxable income. (You do not have to itemize to do this.) The result will be the same as if you did payroll contributions.

In addition to having a high deductible health plan (HDHP), to qualify for an HSA you cannot:

• Be claimed as a dependent on the previous year’s tax return.
• Be covered by Medicare.
• Have any other health coverage, aside from certain exceptions as outlined by the IRS.²

As long as you are covered by an HDHP on December 1, you can make the full contribution for the year, even if you’ve had the plan for only a short time. But if you didn’t have an HSA-eligible policy for the full year, you must keep it for the entire following calendar year or pay a penalty.

Anyone with an HDHP can set up an HSA. As with an IRA, you just need to select a custodian. Often, banks, insurance companies, and credit unions are HSA custodians, but some of the best ones specialize in the business of HSA custody, such as Health Equity, The HSA Authority, or Further.  You can compare hundreds of HSA providers’ investing options and fees at www.hsasearch.com.

There are basically two ways people tend to use an HSA: for spending or for investing. You can do both, but most people gravitate to one or the other. Frankly, I think that most people who spend down their HSA accounts each year don’t really understand the enormous advantages of using an HSA as a tax-advantaged long-term health care savings plan. Probably a lot of people confuse HSAs with use-it-or-lose-it FSAs (discussed below). Spending your HSA is like buying groceries with the money in your IRA each year. Yes, you need to buy groceries, but don’t use tax-sheltered dollars to do it! Take full advantage of the tremendous benefits of tax-free compounding in your HSA!

If you are inclined to spend the money right away (despite my pleas), look for a custodian with low fees, low minimum requirements, and a debit card to make it easy to use the money. In the past, you could also shop for a high interest rate, but rates paid on balances these days are all extremely low.

If you intend to use your HSA for long-term investing purposes (good for you!) you will want to compare fees but also examine the investment options provided. Low-cost index mutual funds are always a good investing staple. Often you can minimize fees by maintaining a minimum balance (usually $1000) in the “spending” account and transferring the rest to the “investment” account.

The tax advantages of an HSA cannot be over-emphasized. HSAs provide a “triple” tax benefit:  1) contributions are tax deductible (not counted as income), 2) the build-up is tax-free (just like an IRA), and 3) qualifying medical distributions are tax free (no matter when you take them).  This makes the HSA a combination of the best elements of the traditional and the Roth IRA, in a way.  For that reason, for those who qualify, contributing to an HSA should come before even contributing to an IRA.

I would urge you to think of your HSA as a “healthcare IRA.” Don’t spend anything out of it until you absolutely have to—let that tax-free buildup work in your favor.  Instead of paying for current medical expenses, keep the receipts.  You can reimburse yourself out of your HSA even many years later if you have receipts to prove your medical expenditures, even from many years earlier. Although HSA money, like Roth IRA money, should be among the last dollars to be spent, it should always be spent on qualifying medical expenses (or self-reimbursing for such expenses) in order to avoid tax.

In addition to reimbursing yourself for past medical expenses (for which you have meticulously kept receipts!) you can use your HSA money to cover medical expenses in later retirement, such as co-payments, deductibles, prescription drugs, vision and dental care, and a portion of your long-term-care premiums. You can also use the money to pay for your Medicare Part B, Part D or Medicare Advantage premiums. Your spouse can inherit your HSA and use it for the same expenses. ³

Flexible Spending Accounts (FSAs)

Healthcare Flexible Spending Accounts (FSAs) have been around a long time—they were initially established in 1978. Only employers can establish FSAs, and 85% of large companies have them.⁴ Often part of a “cafeteria plan” of employee benefits, FSAs can be used to cover out-of-pocket medical, dental, vision, and pharmacy expenses (prescription only), as well as health insurance co-pays and deductibles.

Employees can generally enroll in their company’s FSA plan either when they begin work or during a specified open enrollment period set by the employer, generally toward the end of the calendar year. You are not allowed to make changes in your choice of how much to set aside unless you have a change in your personal financial status, such as a new birth in the family, death, adoption, marriage, divorce, or change in your insurance coverage. For that reason, it is important that you take the time to analyze your personal situation and make the best decisions regarding your likely future income, projected living expenses, health status, and family situation.

Unlike Health Savings Accounts (HSAs), which were created in 2003, the unspent funds in an FSA generally do not roll over to the next year if not spent. Any funds in the FSA at the end of the year are forfeited. This provision is known as the “use it or lose it” rule. Employers have the option of letting you rollover $500 from your FSA into the following year, or they may give you until March 15 to spend the money, but they aren’t obligated to give you those choices. This requirement has limited the popularity of the FSA, as it is difficult for most people to accurately project their upcoming year’s expenses. 

Healthcare FSAs are like HSAs in that the contributions are made on a pre-tax basis (lowering your taxable income), and withdrawals can be made on a tax-free basis. Contribution limits are somewhat lower for Healthcare FSAs than for HSAs. You can individually contribute at most $2,750 to your FSA this year (2020). Your employer may also contribute over and above that amount, but not all employers do.

On the other hand, while you can only spend out of an HSA what you have already contributed to it, the total amount that you agree to contribute to an FSA in the coming year is available for you to spend on the first day of the year. In other words, if you agree to reduce your income by $1,200 in the coming year for example, the full $1,200 is available to you for qualified expenses on January 1st.

Generally speaking, you cannot participate in both a Healthcare FSA and a Healthcare Savings Account (HSA) in the same calendar year. However, there are exceptions. For example, the FSA might be a “limited purpose” FSA used only for vision, dental, and/or preventive care services, eliminating the possibility of a “double dip” with your HSA.⁴

Health Reimbursement Arrangements (HRAs)

HRAs are much less common than either HSAs or FSAs. HRAs which are offered by employers alongside a health insurance plan as a way to help offset out-of-pocket medical costs for employees. They’re often offered with high-deductible health plans (HDHPs), but not always. Employers determine how much they will contribute to an HRA, and they closely control the spending.

You are free to use funds in an HSA or FSA to pay for approved services and procedures (usually with a debit card linked to the HSA or FSA account). However, with an HRA, you have to pay the expenses upfront and your employer reimburses you once expenditures are approved.

HSAs, FSAs, and HRAs Compared

The chart below summarizes the differences among HSAs, FSAs, and HRAs.⁵

There is no reason to pay more in taxes than you have to. These three tax-smart ways of paying for healthcare expenses may require a bit of effort, but the tax savings will make it well worth your while. If your employer offers an FSA or HRA, by all means participate. If not but you have the chance to select a high deductible health plan, or you are already in one, you can take advantage of a the triple tax benefits of an HSA:  1) contributions are tax deductible (not counted as income), 2) the build-up is tax-free (just like an IRA), and 3) qualifying medical distributions are tax free (no matter when you take them).